Two recent judgments relating to the rights of creditors are shaking the financial markets in India. They have the potential to not just stall the working of the Insolvency and Bankruptcy Code (IBC), but also to dry up the pool of potential investors in stressed assets in India —and, indeed, to clog up the working of the credit markets altogether if they go down as a precedent to be followed. These decisions are by the National Company Law Tribunal (NCLT) in relation to the dues to creditors of the troubled Infrastructure Leasing and Financial Services (IL&FS); and by the National Company Law Appellate Tribunal (NCLAT) with respect to the sale of Essar Steel.
The NCLAT has approved ArcelorMittal’s bid to buy Essar Steel for Rs 42,000 crore — but has overruled the Committee of Creditors (CoC), which had set aside only 10 per cent of that amount for Essar’s operational creditors. The NCLAT has instead said that just under 40 per cent should go to the operational creditors. Banks with exposure to Essar Steel have, at one stroke, seen their payout diminish. In effect, the loans given by the banks — secured creditors — have been put on par with operational creditors. Meanwhile, the NCLT directed that provident funds (PFs) that had lent money to IL&FS, even if not secured, should be treated on par with secured creditors, because the beneficiaries of PFs deserve special treatment. Here, secured and unsecured creditors are being treated equally.
This strikes at the very root of modern finance — which is structured so that multiple risk-return profiles are made available to investors. Secured loans receive a lower interest rate, in return for being first in the line for payouts if something goes wrong. The NCLT and NCLAT have refused to abide by this principle. The Essar Steel creditors have appealed to the Supreme Court (SC), and it is to be hoped that the SC will keep this principle, which underlies the letter and spirit of the IBC, in mind. While it is unfortunate that PFs might make a loss on their exposure to IL&FS, for example, it is up to the guarantors of the PFs in question to ensure that the beneficiaries do not suffer.
If the legal system seeks to protect groups of individuals at the cost of undermining the credit architecture more broadly, it would be counterproductive. Already, in relation to various real estate matters, apartment buyers are being treated on par with financial creditors — which has had a predictable negative effect on credit to real estate in India. If such thinking is extended, as it has been under these two decisions, then not only will foreign funds refuse to invest in stressed assets, but the entire IBC system, predicated on the rights of the CoC to make decisions about the future of the company, will break down. Effective interest rates will also skyrocket, which will hurt all future investments. Besides, financial creditors would rather enforce security at the first sign of financial distress in a firm or choose to vote for liquidation, since in both cases they would stand to make higher recoveries as opposed to a resolution plan under the NCLT. This is like incentivising liquidation. Both in terms of natural justice and consequentialist ethics, there is good reason to re-examine these decisions.